Volatility is rising. The CBOE VIX Index has averaged 25.7 this year, up from its long-term average of 19.5.1 And the average percentile rank for measures of implied equity, bond, currency, and oil volatility are all above the 90th percentile — reinforcing how widespread risks have become.2
That puts the spotlight on liquidity — the ability to buy or sell a security quickly, easily and at a reasonable cost.
Particularly in a volatile market, it’s important to ensure that your portfolio has adequate liquidity should you need to trade. That means reviewing the liquidity profile of your portfolio, as well as the liquidity of individual funds.
As volatility has increased, investors once again have gravitated to exchange traded funds (ETFs) for their key attributes of transparency and liquidity.
VIX vs. ETF Turnover
Created in the wake of the market crash of 1987 to allow investors to trade with limited impact on the securities held by the funds, ETFs provide liquidity when investors demand it most. Investors trust liquid ETFs to express their views and reposition portfolios in uncertain markets. In fact, a majority of respondents to ThinkAdvisor’s “Liquidity Risk: A Changing Landscape” survey view ETFs as more liquid than mutual funds.
Unlike mutual funds, ETFs trade intraday on stock exchanges at market-determined prices. But what’s really unique about ETFs — and especially relevant now — is that their liquidity is supported by two trading markets.
In the secondary market, where most investors trade, ETF liquidity is provided by ETFs trading on exchange. That’s enhanced by the primary market liquidity of the ETF’s underlying securities, which is sometimes even greater than an ETF’s secondary market liquidity.
These two layers of ETF liquidity stem from how they are created and redeemed. And assessing an ETF’s total liquidity begins with understanding the creation and redemption process.
Creation and redemption happens in the primary market and is facilitated by authorized participants (APs). APs are US-registered, self-clearing broker dealers who regulate the supply of ETF shares in the secondary market.
APs create ETF shares in large increments — known as creation units — by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size, which is typically 50,000 ETF shares. The AP then delivers those securities to the ETF sponsor. In return, the ETF sponsor bundles the securities into the ETF wrapper and delivers the ETF shares to the AP. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange.
When demand increases more ETF shares can be created, thus allowing the liquidity of an ETF’s underlying securities to enhance the liquidity of the ETF itself.
When demand decreases, APs redeem ETF shares by reversing this process. Large increments of ETF shares — known as redemption units — are collected in the secondary market and then delivered to the ETF sponsor in exchange for the underlying securities in the appropriate weighting equaling that redemption unit (again, typically 50,000 shares).
Because ETFs can be dissembled back into single securities, the ETF’s portfolio manager typically does not need to buy or sell securities, except for rebalancing purposes.
How Creation/Redemption Works
Source: State Street Global Advisors, June 4, 2022.
Because an ETF’s assets and trading volume ebb and flow, it’s helpful to focus on at least two years of data when conducting both market-based and fund-specific liquidity analysis. Too short of a time period may not allow for multiple market environments to be analyzed. Too long a period could introduce stale data that may not reflect the current market environment and fund profiles.
To analyze the liquidity risk of your portfolio, evaluate these three main factors:
Each of these measures is impacted when volatility pushes investors to perceived safer areas of the market. With this flight to safety, bid/ask spreads may widen. Robust trading volumes may disappear. Stocks trading above their historical valuations may fall back to their multi-year average or lower. And the underlying liquidity for an asset class may be diminished. However, even with less liquidity, ETFs can function as valuable price discovery tools, providing insights into the market’s view on correct market pricing.
As for evaluating individual ETFs, liquidity has become a key component of total cost of ownership (TCO) analysis, especially as the number of ETFs continues to grow.
Here, secondary trading volume is often the first measure of ETF liquidity. However, investors with larger order sizes can source liquidity not displayed on the screen from liquidity providers. And, remember, ETFs are at least as liquid as their underlying constituents at any given point in time.
Naturally, volatility impacts an ETF’s liquidity profile in both the secondary and primary markets. In particular, stress in the equity and bond markets can lead to wider bid-ask spreads for individual funds.
When volatility hits, market makers are forced to widen their spreads to include a buffer for the additional market volatility. To hedge their risk and facilitate orderly trading, market makers often use an array of tools — underlying securities or correlated proxies, such as index futures or other ETFs. Included in an ETF’s spread, this hedging cost is passed along to investors trading in the secondary market.
The extent that an ETF’s bid/ask spread widens depends largely on the fund’s liquidity profile and perceived risk of the asset class. Typically, these wider bid-ask spreads are temporary.
When volatility strikes, it’s common to feel compelled to “do something…anything.” Understanding the liquidity of your portfolio can help you to resist making impulsive trading decisions and to trade efficiently in an increasingly uncertain environment.
If you must trade, don’t use market orders. Also, don’t trade within the first 30 or last 30 minutes of the trading day, when volatility tends to be highest and spreads at their widest.
If you have questions about trading in today’s volatile market, the SPDR Sales Execution and Implementation Team can help. Having built relationships with authorized participants, market makers, liquidity providers, execution trading desks/platforms and stock exchanges, we play an active role in supporting competitive markets and maintaining the SPDR ETF liquidity ecosystem.
In fact, our suite of SPDR ETFs represents 36.1% of the ETF industry’s annual trading volume ($36.0 Trillion) — $510 billion more than Vanguard and BlackRock combined — making State Street SPDR ETFs the secondary market leader. 3
Our vast insight into primary and secondary market activity — as well as our access to numerous proprietary pre-trade liquidity analytics tools — can help you to evaluate execution strategies and meet your objectives, even in a volatile market.
1Bloomberg Finance L.P. as of May 31, 2022.
2Bloomberg Finance L.P. as of May 31, 2022 based on SPDR Americas Research calculations where Currency-implied volatility is measured by the J.P. Morgan Global FX Volatility Index. Rates-implied volatility is measured by the MOVE Index. Oil-implied.
3Bloomberg Finance, L.P., as of 12/31/2021, calculations per SPDR Americas Research.
The difference between the highest price a buyer is willing to pay for an asset and the lowest price the seller will accept to sell. Bid-ask spreads are a key measure of the liquidity of an asset or security.
Exchange Traded Fund (ETF)
An ETF is an open-ended fund that provides exposure to underlying investment, usually an index. Like an individual stock, an ETF trades on an exchange throughout the day. Unlike mutual funds, ETFs can be sold short, purchased on margin and often have options chains attached to them.
The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.
Total Cost of Ownership
The purchase price of an asset plus the costs of operation.
The process of determining the current worth of an asset or a company.
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed in this material are the views of SPDR Research team through the period ended May 31, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Past performance is not a reliable indicator of future performance.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.
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Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
There can be no assurance that a liquid market will be maintained for ETF shares.
In general ETFs can be expected to move up or down in value with the value of the applicable index. Although ETF shares may be bought and sold on the exchange through any brokerage account, ETF shares are not individually redeemable from the Fund. Investors may acquire ETFs and tender them for redemption through the Fund in Creation Unit Aggregations only. Please see the prospectus for more details.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
There can be no assurance that a liquid market will be maintained for ETF shares.
Volatility management techniques may result in periods of loss and underperformance may limit the Fund's ability to participate in rising markets and may increase transaction costs.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.